Mar

9

To look at the issue of margin from a different angle, imagine there are two similar companies who have very different balance sheets: Company A is 100% equity financed while Company B has taken on tonnes of debt and is highly geared. Can the investor roughly replicate the higher risk-return profile of the highly geared company simply by borrowing on margin and investing in the 100% equity financed company?

Yishen Kuik replies:

IMHO, the one has nothing to do with the other.

A company that takes on leverage to conduct its business is exposed to business risks that cause it to be momentarily short of operating cash and therefore unable to make an interest payment. The equity holders are now at the mercy of the bondholders.

If it did not take on leverage, none of this would happen.

The issues that cause a leveraged equity holder to have to sell out of his position are completely different from those that cause a levered company to go into default, and the consequences are completely different as well.